Loss on Sale of Rental Property
Do You Actually Have a Tax Loss?
One of the biggest mistakes that rental property owners make is thinking that they have a tax loss when they do not. This often occurs when a 1031 exchange is made to purchase a rental property. If you've sold a previous property and rolled the proceeds into the new property to avoid capital gains taxes, then the property's basis that you've just sold for a financial loss may not be considered a taxing loss. In a 1031 exchange, the basis in the property is often lower than investors believe it will be.
This is why it is critically important that you know the tax basis of your rental property before you agree to take a loss on the sale of it. You might be taking two hits instead of one! Having a tax gain with an overall financial loss is about the worst situation there is from an investment standpoint.
If You Do Have a Tax Loss, Then You Have Good News
Any tax loss that occurs on the sale of a rental property that you've owned for a year or more qualifies as a Section 1231 loss. Although a loss isn't really “good,” a Section 1231 loss makes the best out of a bad situation. It can be used to reduce any income you may have. Any type qualifies: bonuses, salaries, rental income – if you made money, this kind of loss reduces the amount of profit that you've actually generated.
A Section 1231 loss also can create a situation where you can end up having a net operational loss for the taxing year. If it brings your income below zero, then you can actually carry back your net operational loss for two years and offset your taxable income in those years. If you amend your returns based on your new taxable income levels from the losses, it is possible to recoup some, if not all, of the taxes you paid out in previous years.
If you still have more losses and you've cleared the two previous taxing years AND this year as well, then any additional losses can be carried into the future – up to 20 years. If you don't have any tax payments in the past 2 years, then the entire amount being carried over can go forward into the future as well.
What If I Converted My Residence Into a Rental?
If you know that you could be taking a big loss on a home you've used as a residence, it may pay to change it over to a rental. The house depreciates over its lifetime at a 1/27.5 rate each year, so selling it for a loss may or may not occur. Any loss in value that occurs after converting it to a rental is, however, usually deductible.
It's not always great to take a loss on the sale of a rental property, but tax laws help to ease that pain a little. Every situation is unique, so always be sure to consult with a tax advisor for specific questions about your income situation.
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